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Marginal Costing - Introduction

 Marginal Costing - Introduction

         Like process costing or job costing, marginal costing is not a distinct method of ascertainment of cost but is a technique which applies existing methods in a particular manner so that the relationship between profit & the volume of output can be clearly brought out. Marginal costing ascertains marginal or variable costs & the effect on profit, of the changes in volume or type of output, by differentiating between variable costs & fixed costs. To any type of costing such as historical, standard, process or job; the marginal costing technique may be applied.   

         Under the process of marginal costing, from the cost components, fixed costs are excluded. The difference which arises between the variable costs incurred for activities & the revenue earned from those activities is defined as the gross margin or contribution. It may relate to total sales or may relate to one unit.

         The calculation of contribution for a specific product or group of products is done as follows:

Sales Revenue                                                                                                X
Less Variable cost of production                                                                     X
Contribution                                                                                                    X

         For the business as a whole, contributions earned by specific products or group of products, are added so as to calculate the ‘pool’ of total contribution. The fixed costs of the business are paid from this ‘pool’ & then the part of the total contribution which remains becomes the profit of the business as a whole.

A typical format for marginal costing statement is as below:

Product types or departments          A                     B                     C                    Total

Sales Revenue                                   X                     X                     X                     X
Less Variable cost of production        X                     X                     X                     X        
Contribution                                       X                     X                     X                     X
Less: Fixed Costs                                                                                                    X
Total Profit                                                                                                              X

         Under marginal costing, for the calculation of profits for individual products or departments, no attempt is made- only calculation of individual contributions is done. The fixed cost does not allocated to or gets absorbed by the individual products or departments. Thus, accounting techniques relating to the treatment of fixed costs will not influence the decisions which are based on marginal costing system.

Examples of typical problems which require executive decisions are:

  1. At a lower price should a particular order be accepted or declined?

  2. Should purchase of a particular component be made from an outside supplier or manufactured within the factory?

  3. Concentration should be given on which products?

  4. By which profit-mix, profit will be maximized?

  5. What should be the effect on the business when an existing department is being closed or a new department is being opened?

  6. To make up for wage rise, what should be the additional volume of business?

  7. How by change in sales volumes or sales prices, the level of profit of business be influenced?

Features of Marginal Costing:

  1. Classification of costs into fixed costs & variable costs is done under marginal costing system. Also semi-fixed or semi-variable cots get further classified into fixed & variable elements.

  2. To the product, only variable elements of cost, which constitute marginal cost, are attached.

  3. After the marginal cost & marginal contribution are taken into consideration; price is fixed.

  4. From the total contribution for any period, fixed cost for the period are deducted.

  5. The profitability of a department or product is decided by the marginal contribution.

  6. At variable production cost, the valuation of work-in-progress & finished product is made.

Advantages of Marginal Costing:

  1. As there is involvement of computation of variable costs only in marginal costing, it is easy to understand & operate the same.

  2. Among different products or departments, arbitrary apportionment of fixed costs is avoided & the under-recovery or over-recovery problems are eliminated.

  3. Any attempt of measurement of relative profitability of different products or different departments becomes complicated due to the arbitrary apportionment of fixed costs.

  4. Analysis of contribution, break even charts & analysis of cost-volume-profit-analysis are resulted out of a marginal costing system; for making short term decisions all of these are important.

  5. More uniform & realistic figures are resulted out of marginal costing system because fixed overhead costs are excluded from valuation of stock & work-in-progress.

  6. Apportionment of responsibility of control can be more easily done since to each level of management only variable costs are presented over which they have control.

  7. The effects of their decisions can be more readily seen by all levels of management- sometimes even before taking of an action.

Disadvantages of Marginal Costing:

    1. The process of separating semi-variable or semi-fixed costs into their variable & fixed elements is an arbitrary exercise which at different levels of output may be subject to fluctuations & inaccuracy. Consequently, a substantial degree of error may be contained in the basic cost information which is used in decision making process.

    2. When selling prices are based on marginal costs, great care need to be exercised, as in the long run, all fixed overheads should be covered by the prices & a reasonable margin over & above the total costs should be left.

    3. Under many circumstances, the deduction of contribution made by some production units may be difficult. Thereby the effectiveness of the system is lost.

    4. Since on the basis of variable costs only the valuation of stock of finished goods & work-in-progress is done, they are always understated. As result profit is also understated.

    5. More effective utilization of present resources or by expansion of resources or by mechanization, increased production & sales may be effected. The disclosure of this fact cannot be done by marginal costing.

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